Lecture 6: Theory of Optimum Currency Areas (OCA)

Can benefit from currency union if..

- Countries experience similar shocks - If countries experience different shocks, they must satisfy additional criteria

Characteristics of assessing sustainability of joining a monetary union

1. High degree of price and wage flexibility 2. High degree of labour and capital mobility across borders 3. High degree of fiscal integration 4. Openness of the economy 5. Diversification of production structures

benefits of common currency

1. Lower transaction costs 2. Lower exchange rate risk 3. Greater price transparency

What happens with an asymmetric shock in a currency union?

2 conclusions: - The real exchange rate adjustment can only come from changes in prices and wages - The fixation of exchange rates makes adjustment mechanism via depreciation impossible

labour mobility and migrations

Annual cross-border migration rate for European working age ppl was just .3% of the population. About 1% for total migration. *in comparison migration rate across US is 2.4% annually

What is the main cost of currency union

Countries are constrained to have the same interest rates. -Creates the impossible trinity/inconsistency triangle between monetary independence, exchange rate stability. and financial integration

high degree of fiscal integration

Countries that agree to compensate each other for adverse shocks should form a monetary union. This fiscal flexibility may involve the operation of automatic stabilizers (subsidies, family allowances) or discretionary actions

high degree of labour and capital mobility across borders

Labour and capital mobility provide a substitute for exchange rate flexibility and wage and price flexibility in promoting adjustment. Most economists accept the general approach that prices and wages are sticky in the short term, so they focused on labour and capital mobility.

tax wedge on labour cost

Measures the relative tax burden for an employed person. This includes taxes and other fiscal charges such as social security, work insurance, etc.

high degree of price and wage flexibility

Perfect price and wage flexibility would ensure that markets clear fully. This leaves no role for the exchange rate in the adjustment process or for monetary policy. In other words, the choice of monetary policy or exchange rate regime would have no bearing on the real economy.

Background of OCA Theory

The Optimum currency Area Theory tries to explain whether it makes economic sense for a group of countries to abandon their national currencies. -Theory formulates conditions when this is possible. -OCA determine the economic and political mechanisms which help to re-establish equilibrium in the economy

how big is cost of having same interest rates?

This depends if countries have the same macroeconomic problems (symmetry of economic shocks). If macroeconomic problems are similar then operating under the same monetary policy isn't much of a constraint